With speculation in today's FT that the government is considering changes to pension tax relief for higher earners, Michael Johnson - author of CPS publications 'Pensions: Bring back the 10p rebate' and 'Put the Saver First' - writes on why he believes savings incentives need to change.
The Treasury spends a vast amount each year on incentivising people to save for retirement. In addition to tax relief on contributions (cost: £26.1 billion in 2010-11), there is also the tax-exempt 25% lump sum at retirement (£2.5 billion), NICs relief on employer contributions (£13 billion) and tax relief on investment income (£6.8 billion). Over the last decade, relief on income tax and NICs has totalled a staggering £358.6 billion (excluding tax foregone on the tax exempt 25% lump sum).
Consequently, we should be questioning the effectiveness of retirement saving tax incentives. Today, they are crude and mis-directed, with distribution skewed towards the wealthy, who are increasingly treating pensions tax relief as a tax planning tool, rather than as an incentive to save. Conversely, tax relief is poorly understood by younger workers, and lacks any emotional resonance. The lure of tax relief on pension contributions (at 20% for nearly 90% of the population) is insufficient to overcome pensions’ inherent lack of flexibility. For most people, immediate access to savings is the top priority. Furthermore, pension savings only offer the prospect of a distant, and uncertain return. Consequently, tax relief does little to catalyse a savings culture, thereby exacerbating the looming generational inequality.
The savings incentives framework should be realigned, which would require a preparedness to confront deeply-entrenched vested interests within the industry. More specifically:
• the annual contribution limits for tax relief on ISA and pension saving should be combined at no more than £40,000, with the full limit available for saving within an ISA. This limit could be used as a key cost control lever, with adjustments to it (driven by affordability) becoming a regular feature in the Budget. A combined ISA and pension limit reflects the reality that ISAs, as perhaps the only remaining trusted brand in the savings arena, are popular. Indeed, last year, for the first time, more was invested in Stocks and Shares ISAs (£15.8 billion, up 26% on the previous year) than personal pensions (£14.3 billion), in spite of the latter having the added attraction of up-front tax relief;
• in parallel, higher rate tax relief should be shelved, saving some £7 billion annually and, as a quid pro quo, the 10p tax rebate on pension assets’ dividends and interest income should be reinstated, costing roughly £4 billion per year. Rising interest rates would increase this cost, but also probably herald a recovering economy, aiding affordability. Retaining additional income within pension pots would ensure that the positive power of compounding benefits the individual, rather than the Treasury; and
• the 25% tax-free lump sum concession should be replaced with a 5% “top-up” of the pension pot, paid prior to annuitisation. This would be of more lasting benefit to retirees (the “top-up” would increase people’s annuity income) and would be cost neutral: 20% relief (higher rate relief having ended) on the 25% lump sum equates to the 5% “top up”.